"Curiosity is the Virtue of a Vigorous Mind"...this blog is about the journey of a curios mind in search of Alpha Investments

Tuesday, March 14, 2006

How to minimise investment returns (WB's letter to shareholders continues..)

This bit (on frictional costs and how they lower investment returns) in Berkshire's annual letter to shareholders, deserved a special mention, hence a separate note on the same. Here is the excerpt -

Over the last century, American Businesses did extraordinarily well and investors rode the wave of their prosperity. Businesses continue to do well. But now shareholders, through a series of self-inflicted wounds, are in a major way cutting the returns they will realise from their investments.

The explanation of how this is happening begins with a fundamental truth: With unimportant exceptions, such as bankruptcies in which some of a company's losses are borne by creditors, the most that owners in aggregate can earn between now and Judgement Day is what their businesses in aggregate earn. True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B. And, yes, all investors feel richer when stocks soar. But, an owner can exit only by having someone take his place. If one investor sells high, another must buy high. For owners as a whole, there is simply no magic - no shower of money from outer space - that will enable them to extract wealth from their companies beyond that created by the companies themselves.

Indeed, owners must earn less than their businesses earn because of "frictional" costs. And thats my point: These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have.

To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family. We'll call them the Gotrocks. After paying taxes on dividends, this family - generation after generation - becomes richer by the aggregate amount earned by its companies. Today that amount is about $700 billion annually. Naturally, the family spends some of these dollars. But the portion it saves steadily compounds for its benefit. In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.

But lets assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The Helpers - for a fee, of course - oblingingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So tha family's annual gain is wealth diminishes, equaling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge on it.

After a while, most of the family members realise that they are not doing so well at this new "beat-my-brother" game. Enter another set of Helpers. These newcomers explain to each member of the Gotrocks clan that by himself he'll never outsmart the rest of the family. The suggested cure: "Hire a manager - yes, us - and get the job done professionally." These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, the bigger the slice of the pie now goes to the two classes of Helpers.

The family's disppointment grows. Each of its members is now employing professionals. Yet overall, the group's finances have taken a turn for the worse. The solution ? More help, ofcourse.

It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers. The befuddled family welcomes this assistance. By now its members know they can pick neither the right stocks nor the right stock pickers. Why, one might ask, should they expect success in picking the right consultant ? But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don't suggest it to them.

The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group - we'll call them the hyper-Helpers - appears. These friendly folk explain to the Gotrocks that their unsatisfactory results are occuring because the existing Helpers - brokers, managers, consultants - are not sufficiently motivated and are simply going through motions. "What," the new Helpers ask, "can you expect from such a bunch of zombies?"

The new arrivals offer a breathteakingly simple solution: Pay more money. Brimming with self-confidence, the hyper-Helpers assert that huge contingent payments - in addition to stiff fixed fees - are what each family member must fork over in order to really outmaneuver his relatives.

The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing swen-on sexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, assure the Gotrocks that this change of clothing is all-important, bestowing on its wearers magical powers similar to those acquired by mild-mannered Clark Kent when he changed into his Superman costume. Calmed by this explanation, the family decides to pay up.

And that's where we are today: A record portion of the earnings that would go in their entirety to owners - if they all just stayedd in their rocking chairs - is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic (epidemic) of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses - and large fixed fees to boot - when the Helpers are dumb or unlucky (or occassionally crooked).

A sufficient number of arrangements like this - heads, the Helper takes much of the winnings: tails, the Gotrocks lose and pay dearly for the privilege of doing so - may take it more accurate to call the family the Hadrocks. Today, in fact, the family's frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what would earn if they just sat still and listened to no one.

Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of a genius. But Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, "I can calculate the movement of stars, but not the madness of men." If he had not been traumatised by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.

You can download the "annual letter to shareholders for 2005" from here -